## _wp08243

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---

### I. Background and Objective
- Objective: Analyze wage- and price-setting relations in new EU member states (NMS), with special focus on the link between real wages and productivity.
- Key empirical summary finding:
  - "Our estimates of the empirical wage relation suggest a significant response of almost 80 percent of real wage growth to productivity gains in NMS, once we control for fixed effects."
  - Unemployment rate and an error correction term enter significantly in short-run dynamics; terms of trade do not seem to feed through to real wages.
  - Price-setting estimates suggest strong and significant wage pass-through to inflation.
- Data caveat: Poor quality and restricted availability of labor market data for NMS; panel approach used to enhance power.

### II. Analytical Framework (Wage- and Price-Setting)
- Price-setting (log form):
  - μ is the markup, (y-n) is labor productivity, and (w-p) is the real wage.
- Wage-setting (abstract form):
  - z includes wage-push factors: unemployment benefits, minimum wages, restrictions on firing or hiring, degree of unionization, tax wedge (earnings and payroll taxes), skills mismatch, information problems.
- Mechanism:
  - Wage-push factors create disconnects between wages and effective total compensation, affecting firms’ unit labor costs and wage-setting behavior.
- Price-deflator choice and wage deflation:
  - GDP deflator chosen for real wages and productivity; productivity defined as real GDP per person employed.
  - Nominal wage should be deflated by the private consumption deflator for bargaining decisions; reformulated equation includes θ where θ = 1 implies no pass-through from a terms of trade shock to real consumption wages.

### III. Data, Sample and Econometric Design
- Sample period: 2001-07 (restricted due to poor statistical quality of earlier series).
- Country groups:
  - CEE4: Czech Republic, Hungary, Poland, Slovak Republic.
  - Baltics: Estonia, Latvia, Lithuania.
- Estimation approach:
  - Conventional wage-setting equation estimated following Blanchard and Katz (1999).
  - Specification estimated in differences with an error correction term (ECT) capturing long-run deviation between real wages and productivity.
  - Real wages deflated by the consumption deflator; difference between GDP and private consumption deflators included to proxy changes in terms of trade.
  - All variables in logs.
- Separate estimation for 9 NMS and 18 other EU countries (euro area, Denmark, Sweden, U.K.) over 2001-07.
- Data sources: Eurostat; exceptions: unemployment from IMF WEO and wage flexibility index from World Bank Doing Business.

### IV. Stylized Facts on NMS (2001–07)
- Real wage growth:
  - CEE4: relatively stable and on average well below 5 percent.
  - Baltics and Bulgaria: real wages accelerated but moderated since 2005 in the Baltics and Bulgaria.
  - Romania: real wages remain high and have continued to grow faster than productivity since 2005.
- Productivity:
  - Baltics: sustained productivity gains averaging 7 percent.
  - Other NMS: productivity around 4 percent in the last three years.
- Real unit labor costs (ULC):
  - Began decreasing in 2005 in most NMS, except Romania.
- Unemployment and labor force:
  - Unemployment rates decreased rapidly to single digits in most NMS over the last three years.
  - Inactivity rates remain well above euro area average in most NMS, notably Bulgaria and Romania.
- Migration and remittances:
  - "EU countries report more than 1 million Romanian citizens residing abroad."
  - Remittances (proxied by private transfers) may increase reservation wages and act as a wage-push factor.
- Competition policy:
  - Table 1 reports Index of Competition Policy, 2001-07 (selected entries preserved as presented): 2001: CEE4 2.9; Baltics 2.7; BGR 3.0; ROM 3.0; CZE 3.0; HUN 3.0; POL 3.0; SVK 3.0; EST 3.0; LTU 3.0; LVA 2.3.

### V. Long-Run Wage Equation Results (Panel)
- Long-run responsiveness of real wages to labor productivity:
  - Labor productivity coefficient: 0.86 for EU-18 and 0.86 for NMS.
  - Terms of trade coefficient: 1.02 for EU-18 and 1.24 for NMS.
  - Constant: 1.13 for EU-18 and 0.41 for NMS.
  - R-squared: 0.86 for EU-18 and 0.95 for NMS.
  - Observations: 12663.
- Interpretation:
  - NMS display similar long-run responsiveness of real wages to productivity as EU-18.

### VI. Error Correction and Short-Run Wage Dynamics (Estimation Results)
- Error Correction Term (ECT) and speed of adjustment:
  - ECT coefficient for EU-18 consistent with 0.25 literature value; ECT coefficient for NMS is 0.46 (faster adjustment).
- Section III.A) reported ECT (lagged) entries:
  - Error correction term (lagged): -0.28; -0.46; -0.49; -0.44 [0.07]*** [0.10]*** [0.12]*** [0.11]***
- Labor productivity growth (short-run coefficients reported):
  - 0.42; 0.79; 0.81; 0.93 [0.12]*** [0.12]*** [0.18]*** [0.18]***
- Terms of trade growth:
  - 1.06; 1.20; 1.25; 1.22 [0.13]*** [0.22]*** [0.21]*** [0.22]***
- Unemployment rate short-run effects:
  - -1.13; -3.01; -2.46; -2.40 [0.72] [1.55]* [1.87] [1.56]
- Euro area wage level catch-up (lagged deviation):
  - -0.02 [0.03]
- Remittances:
  - 0.01 [0.00]*
- Constants and goodness of fit:
  - Constant: 0.03; 0.07; 0.08; 0.05 [0.01] [0.04]* [0.04]* [0.04]
  - R2: 0.46; 0.56; 0.57; 0.62
  - Observations: 108; 54; 54; 50
- Notes: Standard errors in parentheses. *,**,*** denote significance at 10, 5, and 1 percent levels, respectively.
- Interpretation:
  - Short-run relationship between real wage growth and labor productivity gains is remarkably strong in NMS.
  - Baseline specification for NMS: response of real wage growth to unemployment is significant and negative, supporting the tighter labor market hypothesis.
  - Unemployment coefficient loses significance once remittances are included, suggesting remittances may proxy higher disposable incomes and/or tighter labor market conditions due to emigration.
  - Likelihood ratio and Wald tests cannot reject that the coefficient on changes in terms of trade is different from one in both EU-18 and NMS, implying terms-of-trade shocks do not feed through to real wage growth (θ equal to one not rejected).

### VII. Price-Setting and Inflation Pass-Through (Estimation Results)
- Long-run price equation (EU-27, 2001-07):
  - Nominal wage (long run): 0.76; 0.76; 0.78 [0.05]*** [0.05]*** [0.05]***
  - Labor productivity: -0.52; -0.69; -0.62 [0.09]*** [0.09]*** [0.09]***
  - Import deflator: 0.16; 0.20; 0.24 [0.05]*** [0.10]** [0.10]**
  - Pricing power: 0.20 [0.09]**
  - Constant: 3.59; 6.37; 5.98 [0.30]*** [0.50]*** [0.52]***
  - R2: 0.90; 0.91; 0.92
  - Observations: 126; 63; 63
- Short-run price error correction model (EU-27, 2001-07):
  - Error correction term (lagged): -0.21; -0.32; -0.35 [0.07]*** [0.11]*** [0.11]***
  - Nominal wage growth (short run): 0.63; 0.64; 0.65 [0.07]*** [0.07]*** [0.07]***
  - Labor productivity growth: -0.28; -0.62; -0.59 [0.13]** [0.18]*** [0.18]***
  - Import deflator growth: 0.14; 0.31; 0.32 [0.04]*** [0.11]*** [0.11]***
  - Changes in pricing power: 0.07 [0.05]
  - R2: 0.56; 0.88; 0.89
  - Observations: 108; 54; 54
- Empirical findings on pass-through:
  - Panel analysis across NMS shows large and significant pass-through from wage growth to inflation.
  - Short-run response of inflation to wage growth is strongly significant and estimated at around 0.65 in both country-group samples (Table 5).
  - Labor productivity growth has the expected negative sign, implying productivity gains mitigate inflationary pressures by reducing firms’ unit labor costs.
  - Import price pass-through to domestic inflation:
    - NMS: coefficient = 0.31 (import deflator → private consumption deflator).
    - EU-18: coefficient = 0.14.
  - Firms’ pricing power (proxied—with an inverted sign—by the EBRD index of competition policy) enters with the expected sign; significant relation holds mainly in the long run.
- Interpretation:
  - Real wages rising above productivity growth are likely to feed through to inflation; wage increases not justified by fundamentals increase unit labor costs and can be transmitted to prices depending on firms’ pricing power.

### VIII. Cross-Country Patterns and Institutional Factors
- Panel average response of real wage growth to labor productivity gains: almost 0.80.
- Country-specific patterns:
  - Bulgaria, Romania, Estonia: actual real wage remains above estimated equilibrium.
  - Estonia and Bulgaria: actual real wage growth outpaced estimated value in 2003-2004; later reverted toward sustainable rates.
  - Romania: real wage growth accelerated since 2005, keeping real wages well above equilibrium.
  - CEE4 (Poland, Hungary, Czech Republic): actual real wage growth tends to be lower than estimated value, keeping real wages below equilibrium; Slovak Republic and Latvia reduced real wages to equilibrium only in more recent years.
- Public sector developments:
  - Real wages in public administration raised by over 20 percent in the last three years in Romania and by 18 percent in the Baltics (especially Estonia and Latvia).
  - Early 2008 data suggest substantial increases also in Bulgaria.
  - Among CEE4, public sector wage growth in last two years outpaced private sector in Czech Republic, Hungary, Poland; contained in Slovakia.
  - Hiring in the public sector has been strong in recent years (except CEE4), exacerbating private sector labor shortages.
- Institutional indicators:
  - Romania: union density 30-35 percent; national-level collective bargaining regulated by law, covering all employees (collective bargaining coverage of 100 percent).
  - Estonia and Bulgaria: limited union density and collective bargaining coverage despite real wages above equilibrium.
  - Romania: one of the widest tax wedges among NMS, but also one of the lowest minimum wages (in levels and as a share of average wages).
- Labor market flexibility (World Bank “Employing Workers” indicator):
  - Labor flexibility remarkably low in Estonia and Romania—countries with largest deviations of real wages from equilibrium.
  - Bulgaria consistently one of the best performers among NMS in terms of labor flexibility.
  - Indices normalized 0 (lowest) to 100 (best).

### IX. Interpretation of Main Drivers (Three Factors)
- The paper identifies three main factors accounting for developments in real unit labor costs in NMS:
  - (i) Catch-up from unusually low wage levels.
  - (ii) Tight labor market conditions owing to strong labor demand, large-scale emigration, and loose public sector wage policies.
  - (iii) Institutional characteristics of the labor market in some cases.
- No evidence from panel estimates of:
  - A direct wage catch-up effect arising from NMS lower wages relative to the euro area.
  - Significant feed-through of terms of trade shocks to real wages.

### X. Policy Implications and Recommendations
- Public sector wage and employment policies should avoid aggravating private sector labor shortages and should help contain inflationary pressures.
- Reforms to raise labor force participation and facilitate more efficient matching of labor supply and demand are essential to reduce wage pressures; beneficial effects from such reforms are likely to take time to materialize.
- Monitoring and addressing wage growth that persistently outpaces productivity is important because:
  - Real wages rising above productivity growth are likely to feed through to inflation and generate pressure for further wage increases.
  - Slow adjustment of wages and markups can prolong nominal and real disturbances.

*Source: _wp08243 - References; _wp08243 - 1. Catch-up from unusually low wage levels; _wp08243 - Section III.A).*

### References..............................................................................................................

### _wp08243 - References

### I. Background
- Objective: Analyze wage- and price-setting relations in new EU member states (NMS), with special focus on the link between real wages and productivity.
- Policy context quotations:
  - "Wage increases should not exceed labor productivity growth and should take into account labor market conditions and developments in competitor countries." — European Central Bank, Convergence Report, May 2008, p.32
  - "Safeguarding macroeconomic stability and sustaining catching-up in a context of rising external imbalances and high inflation requires [...] a public sector wage policy that contributes to overall wage moderation in line with productivity gains." — European Commission, Convergence Report, May 2008, p.54
- Literature gap: Limited analytical work on wage- and price-setting for NMS; existing related studies include Blanchard and Katz (1999), Schiff and others (2006), and Babetskii (2007).
- Key empirical summary finding:
  - "Our estimates of the empirical wage relation suggest a significant response of almost 80 percent of real wage growth to productivity gains in NMS, once we control for fixed effects."
  - Unemployment rate and an error correction term enter significantly in short-run dynamics; terms of trade do not seem to feed through to real wages.
  - Price-setting estimates suggest strong and significant wage pass-through to inflation.
- Data caveat: Poor quality and restricted availability of labor market data for NMS; panel approach used to enhance power.

### II. Wage- and Price-Setting Relations (Analytical Framework)
- Price-setting (log form):
  - Equation (1): [(  )]pulcw ynμμ=+= −− +, where μ is the markup, (y-n) is labor productivity, and (w-p) is the real wage.
- Wage-setting (abstract form):
  - Equation (2): ()wpu  yn zβ−=−  +  −  +, where z includes wage-push factors.
- Definition of z (wage-push factors):
  - Unemployment benefits, minimum wages, restrictions on firing or hiring, degree of unionization, tax wedge (earnings and payroll taxes), skills mismatch, information problems.
- Mechanism: These factors create disconnects between wages and effective total compensation, affecting firms’ unit labor costs and wage-setting behavior.

### III. Additional Considerations
- Data Issues
  - Sample period restricted to 2001-07 due to poor statistical quality of earlier series; Eurostat used as main data source.
  - Exceptions: unemployment rate series from IMF’s World Economic Outlook (WEO) and wage flexibility index from the World Bank’s Doing Business indicators.
  - Regional groupings referenced:
    - CEE4: Czech Republic, Hungary, Poland, Slovak Republic.
    - Baltics: Estonia, Latvia, Lithuania.
  - Price deflator choice:
    - GDP deflator chosen for real wages and productivity; productivity defined as real GDP per person employed.
    - Rationale: "The choice of the GDP deflator as price deflator for real wages and productivity makes the data consistent."
    - Note: GDP deflator growth tends to be higher than private consumption growth during the sample period for most NMS (Figure 1).
  - Wage deflation for bargaining decisions:
    - Nominal wage should be deflated by the private consumption deflator; equation reformulated to account for difference between GDP and private consumption deflators:
      - Equation (2’): ()(   )wpcu  ynppc zβθ−=−+−+ − +, where θ = 1 implies no pass-through from a terms of trade shock to real consumption wages.
  - Employment statistics:
    - Use of payroll statistics or narrower employment estimates may undercount employees and bias productivity upward.
  - Informal economy:
    - "The increasing deshadowing of the gray economy in recent years is likely to raise figures for employment and wages."
- Different Wage-Setting Behavior in Private vs Public Sector
  - Relation between real wages and productivity holds mainly for private sector (industry).
  - Public sector wage determination may differ and exert a wage-push effect via demonstration effects and national collective bargaining.
- Catching Up to Euro Area Average Wages and Prices
  - Convergence pressures, labor mobility, and remittances may act as wage-push factors accelerating nominal convergence in wages and prices.

### IV. Stylized Facts on NMS (2001–07)
- Real wage growth:
  - Real wage growth has been high in most NMS over recent years.
  - CEE4: relatively stable and on average well below 5 percent.
  - Baltics and Bulgaria: real wages accelerated but moderated since 2005 in the Baltics and Bulgaria.
  - Romania: real wages remain high and have continued to grow faster than productivity since 2005.
- Productivity:
  - Persistently high in NMS, especially the Baltics.
  - Baltics: sustained productivity gains averaging 7 percent.
  - Other NMS: productivity around 4 percent in the last three years.
- Real unit labor costs (ULC):
  - Began decreasing in 2005 in most NMS, except Romania.
  - In most countries, increases of real wages above productivity were corrected since 2005; Romania is an exception.
- Nominal wages and price levels:
  - Euro wages increasing in all NMS but wide cross-country differences remain.
  - Romania: rapid wage and price level increases, notably in 2004-05; Bulgaria: smoother adjustment despite lower starting levels.
- Unemployment and labor force:
  - Unemployment rates decreased rapidly to single digits in most NMS over the last three years.
  - Inactivity rates remain well above euro area average in most NMS, notably Bulgaria and Romania.
- Migration and remittances:
  - Large-scale emigration contributes to tight labor markets (e.g., "EU countries report more than 1 million Romanian citizens residing abroad").
  - Remittances (proxied by private transfers) may increase reservation wages and act as a wage-push factor.
- Unit labor costs and consumer prices:
  - ULC and consumer prices have followed similar paths; reductions in ULC generally matched by lower inflation (notably Romania).
- Competition policy:
  - Competition policy improved in all NMS but started from very low levels in Bulgaria and Romania.
  - Table 1 reports Index of Competition Policy, 2001-07 (selected entries preserved as presented):
    - 2001: CEE4 2.9; Baltics 2.7; BGR 3.0; ROM 3.0; CZE 3.0; HUN 3.0; POL 3.0; SVK 3.0; EST 3.0; LTU 3.0; LVA 2.3; (and additional cell values as shown in Table 1 for 2002–2007).

### V. Empirical Questions and Hypotheses
- Two central empirical questions:
  - To what extent have wages diverged from labor productivity in NMS?
  - What accounts for this divergence?
- The paper investigates three main empirical hypotheses to explain deviations between real wage and labor productivity growth (hypotheses outlined in subsequent sections of the paper).

*Source: _wp08243 - References (PDF chapter/section).*

### 1. Catch-up from unusually low wage levels. Countries starting from very low initial

### 1. Catch-up from unusually low wage levels. Countries starting from very low initial wage levels may experience higher real wage growth in order to reach the equilibrium level suggested by the long-run relation between real wages and productivity. Further pressures on real wages may also arise from a direct wage catch-up to euro area nominal wages. This process can be intensified through improvements in households’ incomes due to large remittances.

### Major themes and empirical framework
- Empirical approach
  - Conventional wage-setting equation estimated following Blanchard and Katz (1999).
  - Specification estimated in differences with an error correction term (ECT) capturing the long-run deviation between real wages and productivity.
  - Real wages deflated by the consumption deflator; a variable for the difference between GDP and the private consumption deflator is added to proxy changes in terms of trade.
  - All variables are in logs.
- Short-run wage dynamics (equation form)
  - Real wage growth depends on:
    - Labor productivity growth.
    - Changes in terms of trade.
    - Unemployment.
    - Wage-push factors (added as controls where possible).
  - Long-run adjustment to steady state represented by an ECT.
- Price-setting considerations
  - Wage increases not justified by fundamentals increase unit labor costs and can be transmitted to prices, depending on goods market structure and firms’ pricing power.
  - If wages and markups are not flexible, nominal adjustment to equilibrium is slower and generates longer-lasting output fluctuations.
  - Price-setting empirical specification includes unit labor cost and an import price pass-through effect (mp).

### Econometric design and data
- Sample and period
  - Separate estimation for 9 NMS and 18 other EU countries (euro area, Denmark, Sweden, U.K.) over the period 2001-07.
  - Data source: Eurostat database.
- Long-run wage equation specification (shown as):
  - wit - pcit = αi + β(yit - nit) + θ(pit - pcit) + εt
- Notes on estimation
  - Standard errors reported in parentheses; significance levels *,**,*** denote 10, 5, and 1 percent, respectively.
  - The residual of the long-run wage equation is found stationary and entered in the empirical wage equation together with short-run dynamics; small time dimension requires parsimonious specification with homogeneous dynamics.

### Key empirical findings
- Long-run responsiveness of real wages to labor productivity
  - Labor productivity coefficient: 0.86 for EU-18 and 0.86 for NMS.
  - Terms of trade coefficient: 1.02 for EU-18 and 1.24 for NMS.
  - Constant: 1.13 for EU-18 and 0.41 for NMS.
  - R-squared: 0.86 for EU-18 and 0.95 for NMS.
  - Observations: 12663.
- Error Correction Term (ECT) and speed of adjustment
  - ECT coefficient for EU-18 is consistent with the 0.25 value estimated in the literature for OECD EU countries (Blanchard and Katz, 1999).
  - ECT coefficient for NMS is 0.46.
  - Interpretation: NMS present a faster speed of adjustment toward equilibrium, supporting the hypothesis of a catch-up effect from very low starting wages in some countries (e.g., Bulgaria and Romania).
- Direct wage catch-up to euro area nominal wages
  - No significant evidence of a direct wage catch-up effect to EU levels; NMS countries’ euro wages are lower than the euro area average.
- Short-run dynamics and robustness
  - Short-run relationship between real wage growth and labor productivity gains is remarkably strong in NMS.
  - The labor productivity coefficient moves close to one once other control variables are included.
  - Baseline specification for NMS: response of real wage growth to unemployment is significant and negative, supporting the tighter labor market hypothesis.
  - Robustness caveat: the unemployment coefficient becomes lower and no longer significant once the remittances variable is added.
    - Larger remittances in percent of GDP may proxy higher disposable incomes and/or tighter labor market conditions due to emigration flows.
  - Likelihood ratio and Wald tests cannot reject that the coefficient on changes in terms of trade is different from one in both EU-18 and NMS, suggesting that shocks to the terms of trade do not pass through to real wage growth (i.e., a θ equal to one in the underlying equation is not rejected).

### Implications and interpretation
- Catch-up dynamics
  - Faster ECT in NMS indicates stronger corrective forces moving real wages toward the long-run relationship with productivity, consistent with catch-up from low initial wage levels.
- Labor market tightness and migration/remittances
  - Tight labor market conditions and large migration flows can exert upward pressure on wages, particularly in high-productivity sectors with spillovers to less productive sectors.
  - Remittances complicate interpretation: they may reflect higher household incomes and mask or proxy labor market tightness arising from emigration.
- Price-setting and inflation risks
  - Wage increases outpacing productivity raise unit labor costs and, depending on firms’ pricing power and market structure, can be transmitted to inflation and generate wage-price spirals.
  - Slow adjustment of wages and markups can prolong nominal and real disturbances.

*Source: _wp08243 - 1. Catch-up from unusually low wage levels. Countries starting from very low initial*

### Section III.A).

### _wp08243 - Section III.A)

### Wage Error Correction Model Estimation (EU-18, 2001-07)
- Specification: Δ(w_it - pc_it) = α + βΔ(y_it - n_it) + γECT_it-1 + θΔ(p_it - pc_it) + δu_it + ε_t
- Error correction term (lagged): -0.28; -0.46; -0.49; -0.44 [0.07]*** [0.10]*** [0.12]*** [0.11]***
- Labor productivity growth: 0.42; 0.79; 0.81; 0.93 [0.12]*** [0.12]*** [0.18]*** [0.18]***
- Terms of trade growth: 1.06; 1.20; 1.25; 1.22 [0.13]*** [0.22]*** [0.21]*** [0.22]***
- Unemployment rate: -1.13; -3.01; -2.46; -2.40 [0.72] [1.55]* [1.87] [1.56]
- Euro area wage level catch-up 1/: -0.02 [0.03]
- Remittances: 0.01 [0.00]*
- Constant: 0.03; 0.07; 0.08; 0.05 [0.01] [0.04]* [0.04]* [0.04]
- R2: 0.46; 0.56; 0.57; 0.62
- Observations: 108; 54; 54; 50
- Notes: Standard errors in parentheses. *,**,*** denote significance at 10, 5, and 1 percent levels, respectively.
- 1/ Lagged deviation of euro area wage (in euros) from country wage (in euros).

### Price Equation (Long-Run) Estimation (EU-27, 2001-07)
- Specification: pc_it = α_i + β w_it + γ(y_it - n_it) + θ(p_it - pc_it) + ε_t
- Nominal wage (long run): 0.76; 0.76; 0.78 [0.05]*** [0.05]*** [0.05]***
- Labor productivity: -0.52; -0.69; -0.62 [0.09]*** [0.09]*** [0.09]***
- Import deflator: 0.16; 0.20; 0.24 [0.05]*** [0.10]** [0.10]**
- Pricing power: 0.20 [0.09]**
- Constant: 3.59; 6.37; 5.98 [0.30]*** [0.50]*** [0.52]***
- R2: 0.90; 0.91; 0.92
- Observations: 126; 63; 63

### Price Error Correction Model Estimation (Short-Run) (EU-27, 2001-07)
- Specification: Δpc_it = α + βΔw_it + γΔ(y_it - n_it) + δECT_it-1 + θΔ(p_it - pc_it) + ε_t
- Error correction term (lagged): -0.21; -0.32; -0.35 [0.07]*** [0.11]*** [0.11]***
- Nominal wage growth (short run): 0.63; 0.64; 0.65 [0.07]*** [0.07]*** [0.07]***
- Labor productivity growth: -0.28; -0.62; -0.59 [0.13]** [0.18]*** [0.18]***
- Import deflator growth: 0.14; 0.31; 0.32 [0.04]*** [0.11]*** [0.11]***
- Changes in pricing power: 0.07 [0.05]
- R2: 0.56; 0.88; 0.89
- Observations: 108; 54; 54
- Notes: Standard errors in parentheses. *,**,*** denote significance at 10, 5, and 1 percent levels, respectively.

### Empirical Findings on Pass-Through and Productivity
- Panel analysis across NMS shows large and significant pass-through from wage growth to inflation.
- Short-run response of inflation to wage growth is strongly significant and estimated at around 0.65 in both country-group samples (Table 5).
- Labor productivity growth has the expected negative sign, implying productivity gains mitigate inflationary pressures by reducing firms’ unit labor costs.
- Impact of an increase in unit labor costs on inflation in NMS is limited if nominal wage increases are matched by productivity gains.
- Import price pass-through to domestic inflation:
  - NMS: coefficient = 0.31 (import deflator → private consumption deflator).
  - EU-18: coefficient = 0.14.
- Firms’ pricing power (proxied—with an inverted sign—by the EBRD index of competition policy) enters with the expected sign; significant relation holds mainly in the long run.

### Wage-Setting Variation across NMS: Public Sector and Institutional Characteristics
- Panel average response of real wage growth to labor productivity gains: almost 0.80.
- Country-specific patterns (Figure 6):
  - Bulgaria, Romania, Estonia: actual real wage remains above estimated equilibrium.
  - Estonia and Bulgaria: actual real wage growth outpaced estimated value in 2003-2004; later reverted toward sustainable rates.
  - Romania: real wage growth accelerated since 2005, keeping real wages well above equilibrium.
  - CEE4 (Poland, Hungary, Czech Republic): actual real wage growth tends to be lower than estimated value, keeping real wages below equilibrium; Slovak Republic and Latvia reduced real wages to equilibrium only in more recent years.
- Public sector developments (Figure 7):
  - Real wages in public administration raised by over 20 percent in the last three years in Romania and by 18 percent in the Baltics (especially Estonia and Latvia).
  - Early 2008 data suggest substantial increases also in Bulgaria.
  - Among CEE4, public sector wage growth in last two years outpaced private sector in Czech Republic, Hungary, Poland; contained in Slovakia.
  - Hiring in the public sector, especially public administration, has been strong in recent years (except CEE4), which may exacerbate private sector labor shortages given tight labor markets and excess demand for skilled workers (Figure 8).
- Institutional factors:
  - Romania: union density 30-35 percent; national-level collective bargaining regulated by law, covering all employees (collective bargaining coverage of 100 percent).
  - Estonia and Bulgaria: despite real wages above equilibrium, have limited union density and collective bargaining coverage.
- Nonwage labor costs and other indicators:
  - Romania: one of the widest tax wedges among NMS, but also one of the lowest minimum wages (in levels and as a share of average wages).
  - Changes in tax wedges and minimum wages have been marginal in most countries in recent years and do not explain short-run real wage dynamics.
- Labor market flexibility (World Bank “Employing Workers” indicator, Table 6):
  - Labor flexibility remarkably low in Estonia and Romania—countries with largest deviations of real wages from equilibrium.
  - Bulgaria consistently one of the best performers among NMS in terms of labor flexibility.
  - Indices are normalized 0 (lowest) to 100 (best); individual component scores listed for comparability in Table 6.
  - Caution: correlation between labor flexibility and real unit labor cost developments should be interpreted carefully given methodological shortcomings in the index construction.

### Policy Implications and Conclusions
- Three main factors account for developments in real unit labor costs in NMS:
  - (i) Catch-up from unusually low wage levels.
  - (ii) Tight labor market conditions owing to strong labor demand, large-scale emigration, and loose public sector wage policies.
  - (iii) Institutional characteristics of the labor market in some cases.
- No evidence from panel estimates of:
  - A direct wage catch-up effect arising from NMS lower wages relative to the euro area.
  - Significant feed-through of terms of trade shocks to real wages.
- Parallel price-setting estimates indicate strong and significant wage pass-through to inflation; real wages rising above productivity growth are likely to feed through to inflation and generate pressure for further wage increases.
- Policy recommendations:
  - Public sector wage and employment policies should avoid aggravating private sector labor shortages and should help contain inflationary pressures.
  - Reforms that raise labor force participation and facilitate more efficient matching of labor supply and demand are essential to reduce wage pressures; beneficial effects from such reforms are likely to take time to materialize.

*Italic: Source — _wp08243 - Section III.A).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2008/_wp08243.pdf_